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Interest Rates at their Scariest: What You Can Do About It

NEW YORK (TheStreet) -- Uncertainty over how the Federal Reserve plans to unwind its unprecedented monetary policy has created a tricky environment for interest rates over the next 12 months or longer.

Given the enormity of the Fed's bond buying over the past 14 months, it's terribly unclear how the gargantuan task of trimming the Fed's balance sheet will actually be carried out.

The critics say move carefully, but what does that mean? Move too fast, and the Federal Reserve risks hurting the recovery. Move too slowly, and the Fed risks higher inflation. In either outcome, the central bank could be forced to readjust its tapering pace with little warning, risking the provocation of interest rate volatility and increasing unpredictability in the stock, bond and currency markets.

There's just no telling from which direction the Fed could adjust its taper because in practice, the Fed's monetary policy stance will likely be more reactive than planned in the coming months.

Roger Aliaga-Diaz, the Philadelphia-based senior economist at mutual fund giant Vanguard Group, says he's comfortable estimating that interest rate volatility may be higher than normal in 2014. Malvern, Pa.-based Vanguard Group manages $2 trillion in U.S. and international investments.

"We're in uncharted territory," said Aliaga-Diaz during an interview with TheStreet on Jan. 10. "Not even the Fed knows what it is going to do next. They don't know it. They're looking at the same information that we are looking at. They are taking the decisions as the information comes in, and they are going to respond to those changes on the spot, which means that trying to time the market is really a useless exercise."

Indeed, the central bank itself, even with its economic research staff of more than 450 economists, has been thrown for a loop on the economic outlook as the labor force pool continues to shrink despite leading indicators such as manufacturing activity signaling continued expansion; the latest government job report showed roughly 400,000 people dropping out of the labor force in December against job gains of merely 74,000. For quite some time, the Fed had thought that as the economy improved, there'd be a pickup in the number of Americans returning to the labor market. But on many occasions, economic data has been counterintuitive.

Further adding to rate agitation risks is the possibility that the markets may have more and more trouble distinguishing between tapering and tightening as new economic forecasts come in.

In trying to walk a fine line, the central bank will likely continue to opt for a conservative, $10 billion a month bond tapering until it can extract and confirm longer-term trends from the volatile, monthly government job report, said Aliaga-Diaz.

The Fed will also keep an eye on wage pressures. Aliaga-Diaz says that a wage increase of 3% to 4% annually, from 1.9% in the third quarter, could signify the beginnings of a tightening labor market preceding increasing inflation.

In the face of heightened volatility risk, investors are often told that the best way to go is to diversify; to have a good mix of equities and fixed income. But not all diversified portfolios are created equal.

For instance, Vanguard studies have shown that the more plain vanilla, 60%/40% equity/fixed-income investment is always able to protect against volatility because of the negative correlation between stocks and bonds. Thus, if interest rates were to spike on an improving economy, hurting bond allocations, equities, thriving on economic growth, would more than compensate for the losses. On the other hand, if stocks were to pull back on a drop-off in economic growth as investors also consider the large, almost 30% return for U.S. equities in 2013, the likelihood of renewed interest rate declines would trigger an instant buffer from fixed-income gains.

This has set a high hurdle for the much more complex and riskier, alternative, long-short bond and equity funds. Vanguard studies show that during extremely volatile times such as the 2007-2008 global financial crisis, frequent misses and exorbitant fees often eclipsed any alpha realized from the exposure to a variety of alternative investments. One of the key risks carried by alternative investments is having to execute market timing strategies, according to Aliaga-Diaz.

With the interest rate environment still uncertain today, the economist says it could be very difficult to play the current market in the short-term, or the few months to one-year time horizon, and is advising against drastic portfolio changes.

"Interest rate volatility should be feared by investors," Aliaga-Diaz explained.

Adjustments can be made to the basic, 60/40 diversified split based on an investor's life cycle. A 90% equity and 10% bond portfolio would be suitable for a younger worker years away from retirement and therefore able to tolerate more risk, says Aliaga-Diaz. Those retiring in the next three to five years may opt for a more conservative 20% equity, 80% bond allocation.

Here, Aliaga-Diaz discusses the specificities of the composition of an interest rate volatility-protected portfolio.

Andrea Tse: Would you recommend investing in fixed-income instruments of longer or shorter maturities to help offset stock volatility risks driven by expectations of a more volatile interest rate environment?

Aliaga-Diaz: I think that after the big run in equity markets last year, one way to think about how to invest for the year forward is really in terms of rebalancing your portfolio. At Vanguard, we tend to look at a longer, three- to five-year horizon from the point of view of asset allocation and portfolio construction.

So suppose you were invested at the beginning of last year a little bit in bonds -- maybe 30% bonds and maybe 70% in the stock market. After the 30% return for the year, your portfolio now looks completely different than it looked at the beginning of 2013. So if your investments are still the same, it's probably a good time to say, "okay, let's bring that portfolio back in line with my original investment plan."

The 70%/30% now looks much more different, right. And in that sense, some re-allocation out of equities into bonds would make sense. Now, I wouldn't call for a complete move out of equities. The interest rate environment is complicated too, so it's not that bonds are going to completely cover uncertainties with respect to the markets. You probably want to be cautious. I wouldn't say that you should alter your regional investment plans completely.

In terms of what fixed-income instruments, that depends on your investment horizon. If you're saving for something that is really close in time, in the next three years or so, usually short-duration bonds are better because you don't want this slow-duration risk in your portfolio from long-term bonds. If you're saving for retirement or to send the kids to college, things in the 10-year type of framework, I wouldn't give up the yield of a long-term bond. Even though it's expected to be more volatile than the short-term bond, the long-term bonds compensate with the higher yield.

l'd diversify the portfolio with a little bit of short-term bonds, a little bit of long-term bonds. That would be the best way, from Vanguard's perspective.

And within that, you'd probably like to have a little bit of every sector of the bond market. I want to have government bonds, I also want to have TIPS (Treasury Inflation-Protected Securities), I also want to have credit and high yield.

We don't believe too much in trying to time every little segment of the bond market year to year. For the regular investor with a purpose, that doesn't really pay off.

Tse: What should be the approach to speculative-grade U.S. stocks versus high-quality U.S. equities, taking into account the uncertainties about the future actions the Fed might take? In this context of uncertainty, could an expansion into international and emerging markets be warranted?

Aliaga-Diaz: I think the Fed policy really has benefited all these assets in general -- we have seen equity markets this year in general do really, really great. I'm not sure if on a risk-adjusted basis speculative-grade stocks would have really done much better than the average market. Certainly when we talk about international and emerging markets, they didn't right. So I think that it's still a good idea to be exposed to every segment of the market.

We're not really making a call on any sector. Our expectations for international equity markets is very much in line with the U.S., based on valuations. Valuations are not that much different. In the developed markets, for the U.S., for Japan, for the UK, for Australia, valuations are above normal.

With the emerging markets, it's true the valuations are lower, which you would think is an attractive feature, but at the same time, remember that the emerging markets also are facing a little bit of a slowdown, a structural slowdown if you will, including China. They are not growing at the same pace as they had been growing in the past. This 10% growth of China, this 7% growth of emerging markets, it's more down to more stable.

So the point is, the fact that emerging market valuations are lower than developed doesn't mean that the emerging markets are going to outperform. There's a normal return expectation for emerging.

I would definitely suggest investing in emerging as a diversifier and no more than a market cap allocation. We don't see that as an especially attractive place for any particular reason.

On the equity market side, you want value, you want a small company, you want growth companies, you want international. But remember, the U.S. is half the world and emerging markets are just 10% of the world, so you don't want to overdo emerging markets.

Market capitalization again is clearly a good indication of how to build that equity portfolio.

Tse: With increased interest rate volatility, should the foreign exchange market be avoided altogether, or could options and forward contracts offer encouragement, protecting against rapid fluctuations?

Aliaga-Diaz: It's very difficult to see what value add currencies bring to a portfolio. If interest rates are volatile, currencies are doubly volatile because remember, the currency at the end of the day depends on the interest rate decisions of two central banks. The domestic country and the foreign country. So if it's difficult to predict the interest rates, it's even more difficult to predict currency moves.

You could say, "well look, I think the Fed is going to taper this year and is moving ahead of us in advancing the word, most likely the dollar is going to get stronger." You can make that argument. We can all agree on that. Most economies and the people that you talk to will tell you it's probably going to get stronger this year, which means you're not going to earn anything from trying to ride that dollar trend because it's already priced in the market. So that's the whole thing with currencies, is that they are so forward-looking, the market works so quickly and efficiently, that unless you have some very nice model or very sophisticated information that nobody else has, you are right, it's very difficult really to put a currency in your portfolio and to try to work with that.

From a portfolio construction perspective, currencies really look like a source of uncompensated risk. It looks like a lot of volatility with no clear return. The short answer is get rid of currencies as much as you can, especially in terms of fixed-income investments. Because suppose you invest in international bonds. If those bonds are denominated in foreign currencies, your assets, your investments will have the volatility of the bond itself, plus the huge volatility of the currency, which you remember is two, three times the volatility of the fixed-income assets.

On equities, you're fine, but there is a whole cost of hedging the currency on the equity side.

Definitely, yes, it's not good to get into currencies especially in a year like this one because there will be volatility in interest rates. There will be a lot of forces driving the dollar and developed market currencies back down.

Tse: Modeling for rising interest volatility, what is your current forecast for U.S. high-grade and high-yielding corporate bonds, and U.S. government bonds?

Aliaga-Diaz: We're clearly in an environment of rising rates, and as you say correctly, with volatility. It's not just a linear movement right. There will be ups and downs because the Fed exit and Fed tapering is going to be a multi-step, multi-year process.

This environment is going to persist this year and probably into the next three, so our outlook for fixed-income returns is very modest. Our average return for the aggregate bond market is in the 2% to 3% range for the next five to 10 years. That's very low compared to the last five to 10 years. Expectations are subdued relative to normal for here and the next three to five years.

In terms of the segments; look, for corporates, for high yields -- the spreads have basically narrowed so much since the financial crisis and are back to something close to normal. The main factor driving those returns right now is the Treasury yield curve, right; the outlook for interest rates. So that really dominates the return expectations.

Of course, volatility is higher there too.

If we were to have a stronger year, stronger than expected, interest rates may increase more than expected, and that would hurt government bonds. But corporates bonds would at least offset part of that negative environment by a spread contraction. So we see high-yield and corporate bonds more as a way to diversify your bond portfolio than as a sector that you would go to for return.

Where diversification wouldn't work is if growth was less than expected because in that case, your corporate bonds, your high-yield bonds probably wouldn't do that well, and your Treasury bonds would do a bit better right.